Category: SR&ED

Asset Sale vs Share Sale

Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.

However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:

  1. The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
  2. Shares of small business corporations are much more complex beasts to acquire and may include undisclosed  liabilities or other “surprises” that buyers are understandably nervous about acquiring

Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.

Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.

As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.

The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.

Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.

Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.

For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.

CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY

Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.

Selling intellectual property developed by a technology company now results in a capital gain. With capital gains, only 1/2 of the gain is taxable. The remaining un-taxed half  can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).

So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.

While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Usually buyers will attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly. This may result in fully taxable “recaptured” depreciation.

For entrepreneurs that have done this before, be aware that the rules around gains on the sale of what used to be “eligible capital property” have changed in the last few years. Clearly each company’s particular circumstances will be unique. So it pays to get advice from a tax professional that you trust.

 

 

Differing Views of Innovation in Canada

Do concerns regarding the effectiveness of Canada’s SR+ED Program stem from an incomplete understanding of the state of innovation in Canada?

 As recently as September 9th of 2013, the Conference Board warned that “Canada’s economy is on a ‘path to mediocrity’ as innovation lags”. At about the same time the Startup Genome was reaching a much different conclusion. Their dataset was heavily skewed towards early stage startups. The report was co-authored by a number of entrepreneurs, included contributions from Steve Blank (Stanford University) and Ron Berman (UC Berkeley), and was supported by Telefónica Digital – a global business division of Telefónica S.A.

According to STARTUP GENOME study, Toronto, Vancouver and Waterloo are 8th, 9th, and 16th respectively in terms of their importance as global technology hubs. If this is true – and I expect that it is – it may be in large part due to our generous tax incentives. While the US dominates with 6 recognized technology hubs, Canada is clearly performing well with 3 in the top 20.

In their view the greatest challenge facing early stage technology companies is clearly access to capital for commercialization:

Excerpts from STARTUP ECOSYSTEM REPORT 2012:

  • “If Toronto does not improve its funding climate, entrepreneurs may relocate to the nearby Startup Ecosystems of NYC and Boston where funding prospects are much better.”
  • “Toronto’s startup ecosystem is self-sufficient. However, policy makers can help closing the funding gap by attracting late-stage venture funds through tax breaks and incentives, and investor-friendly policies.”
  • “The funding climate for startups in Vancouver is insufficient, with startups receiving 80% less funding than startups in SV. They receive 72% less in Stage 2 (Validation) and 97% in stage 4 (Scale).  The late stage funding market basically doesn’t exist for Vancouver startups.”

Perhaps the Startup Genome’s perspective is different because they are closer to the action and focused more on start-ups than the Conference Board of Canada. Certainly companies at this very early stage lack resources and experience. As a result, in some ways they actually need more sophisticated help than their later stage counterparts.

In any event it is important to recognize our successes and I believe that Canada’s SR&ED incentive program continues to be a success. The emergence of Toronto, Vancouver and Waterloo as global technology hubs certainly owes a debt to the SR&ED program.

In recent years there has been a great deal of discussion about Canada’s inability to leverage our investment in R&D incentives to improve productivity. I believe that it is the lack of venture capital for commercialization that is the real culprit. However there are certainly some ‘intellectuals’ who have an almost religious aversion to government incentives of any kind. In fact we shouldn’t forget that our current prime minister is a former head of the National Citizens Coalition – a right wing ‘think tank’ that closely resembles the Tea Party in the US.

 CONCERNS WITH THE EFFECTIVENESS OF THE SR&ED PROGRAM

The SR&ED program was originally introduced by Canada’s progressive conservatives in 1985. At the time Canadians were viewed primarily as ‘hewers of wood and drawers of water’ and R&D was done in the corporate headquarters of US-based multinationals.

Recently concerns in Ottawa around the effectiveness of the SR&ED program culminated with the Jenkins Report that made the same mistake that the Conference Board made in September of 2013″

…from the Jenkins Report (2011):

“the panel believes the government should rebalance the mix of direct and indirect funding by decreasing spending through the SR&ED program and directing the savings to complementary initiatives strategically focused on serving the needs of innovative Canadian firms, especially small and medium-sized enterprises”

…from the Conference Board of Canada (2013):

“The federal government recognizes that, despite its high level of federal R&D support, Canada continues to lag other countries in business R&D spending, rates of commercialization of new products and services, and productivity growth”’

The notion of reducing or eliminating the $3.6 billion SR&ED program sits very well with a government that detests taxation – particularly leading up to an election year. But don’t hold your breath waiting for Jenkins’ “complementary initiatives strategically focused on serving the needs of innovative Canadian firms, especially small and medium-sized enterprises”. These kind of direct funding initiatives will clearly not make it before the election budget is delivered, since the beneficiaries are too far removed from – and misunderstood by – middle class voters that all politicians are trying to appeal to.

For traditionalists perhaps it is comforting to realize that Canada is once again becoming a primarily resource-based economy. We appear to have pinned our hopes on the oil sands in Alberta and liquefied natural gas in BC – to the dismay of manufacturers in Ontario and Quebec. Canadians can now choose to firmly embrace the 19th century and ignore those troubling ‘left-wing” notions of climate change and evolution – that our avowedly fundamentalist prime minister seems to have such difficulty with.

The SR&ED Audit – Q&A

WHEN SHOULD CLAIMANTS CREATE TECHNICAL DOCUMENTATION?

(and when should they assemble it?)

CRA2-150x150

Preparing for an “SR&ED” (Scientific Research and Experimental Development) tax audit should really begin well before your company receives notification that your claim is under review. In fact your company should begin assembling supporting documentation at the same time that you decide to perform eligible SR&ED.

As we’ll see later on from the audit letter itself (see Section 3 on page 2 of the letter), there is an expectation that the documentation was developed at the time the work was being performed. It has been our experience that claimants like to assemble that information only after they receive notification of audit. Presumably they do this in the hopes that they won’t be audited. There are 3 serious problems with this approach:

The chances of being subject to an audit have increased significantly in recent years. It is our belief that claims prepared on a contingent (i.e. success-based) basis receive special attention from CRA. Regardless of the engagement terms, the doubling of SR&ED audit staff means that an SR&ED audit is far more likely.

  1. Documentation assembled after the fact may not have existed before the audit letter was issued – and therefore can’t be construed as ‘contemporaneous documentation‘. If this is apparent to the auditor, the CRA might elect to deny your claim in its entirety for lack of ‘acceptable’ documentation.
  2. The CRA generally provides 30 days of lead time to assemble supporting documentation. However they don’t communicate by email, but by letter or fax. This effectively reduces the available time to respond by a week or so – and as you’ll see, the amount of documentary evidence requested is considerable – particularly if it wasn’t identified before the claim was filed.

 

DO CONTINGENT FEES INCREASE AUDIT RISK?

Commencing in January of 2014, claimants are required to disclose the nature of any billing arrangement with a third party claim preparer. While the CRA denies that this section is used to screen files for audit, the CRA would hardly disclose how they in fact do screen files for audit – since this is really their ‘secret sauce’.

Certainly it is our experience that files prepared on a contingent basis are far more likely to be audited than those done on an hourly basis.

 

 WHAT KIND OF DOCUMENTATION DOES THE CRA EXPECT?

SR&ED CHRONOLOGY:

The CRA expects claimants to develop ‘contemporaneous’ documentation detailing plans to overcome technological uncertainties and achieve the desired advancement.

Note that the suggested format presupposes sophisticated activity-based costing – from small businesses that are often challenged maintaining rudimentary books and records on a timely basis.

MAPPING SR&ED TO PRODUCT DEVELOPMENT – WHAT IS THE CHALLENGE?

The Income Tax Act requires that SR&ED activities be “related to a business of the taxpayer”.

In fact 95% or more of SR&ED claims relate to the experimental development of new and improved products or processes – which clearly relate to a business. However even the most sophisticated claimants have difficulty distinguishing between the new features of the product or process and the technological advancement required to deliver these ‘new features’.

The engineers who develop those new products don’t explicitly hypothesize about how to overcome technological uncertainties. Instead they focus on development plans for the new features or products. Determining what work is eligible usually involves inferring from the development plan, what technological uncertainties existed and what their ‘hypothesis’ was – often many months after the work was done.

All of which makes it difficult for them to provide contemporaneous documentation of their SR&ED activities – since contemporaneous documentation exists for the entire product development process – and not the more narrowly-focused SR&ED activities.

EXAMPLE OF AN AUDIT LETTER

TECHNOLOGICAL ELIGIBILITY: THE NEW NORMAL

JENTEL MANUFACTURING CASE RAISES THE BAR

A case decided in May of 2011 has had an enormous impact on the current assessing practice of CRA with respect to determining eligibility of SR&ED projects.

While about 95% of claims involve ‘experimental development’ (“ED”) – as opposed to scientific research (“SR”) – the judgment brings into question whether most ED is even eligible.

According to Justice Steven K. D’Arcy:

“In my view, the work involved the Appellant using existing manufacturing processes and existing materials in an attempt to improve its existing product. This involved routine engineering and standard procedures.”

 

The law reads:

 

“scientific research and experimental development” means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is

. . .

(c) experimental development, namely, work undertaken for the purpose of achieving technologicaladvancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto.”

 

ED invariably involves the use of standard engineering procedures. The truth is that no business sets out to achieve ‘technological advancements’. They set out to build or improve products and services. They necessarily must accomplish this by using standard engineering practices and techniques – since they use engineers and not scientists.

 

Unfortunately the judge seems to have imposed a requirement that the technological uncertainty be explicitly isolated at the beginning of a project, along with an hypothesis for resolving the uncertainty. This is not what engineers do – particularly not in a small business setting. For them the hypothesis is implicit in the development plan.

 

Since that decision was reached, the CRA has doubled their audit staff. They are looking for evidence of:

 

  1. The early identification of the technological uncertainty
  2. An understanding of the difference between ‘routine’ and ‘experimental’ development (I.e. evidence that some sort of ‘filtering’ has taken place)
  3. Timesheets in support of SR&ED projects
  4. A systematic approach involving prototypes, trials and tests

 

This is an unrealistic expectation – particularly when it comes to startups and very early stage companies with limited resources. However it has now become the new normal. And companies that wish to benefit from our otherwise generous SR&ED tax incentives, need to begin to implement procedures that readily produce that kind of evidence.

CRA Doubles Size of Vancouver SR&ED Audit Team

The Vancouver contingent of SR&ED auditors has doubled from 2012 levels. At the same time, the amount of incentives being assessed is declining. With more staff, auditors are becoming more demanding so claims that are poorly documented are very likely to be reduced.

For startups and first-time claimants this can be difficult. Even experienced claimants routinely confuse business projects with SR&ED projects:

Company project versus SR&ED project

A distinction must be drawn between a company project and an SR&ED project. “Company pro-ject” is a generic term referring to undertakings by a company to have an impact on its business; for example, building new facilities or expanding facilities, developing new products and product lines, changing business practices, upgrading processes and facilities, and engineering projects. A company project is a project with a commercial purpose, whereas the purpose of an SR&ED project is for the advancement of scientific knowledge or for achieving technological advancement. Paragraph (c) of the definition of SR&ED recognizes, and in fact requires, that the experimental development be done for the purpose of achieving technological advancement in the context of creating new or improved materials, devices, products or processes.
An SR&ED project usually occurs as a subset of a company project. Therefore, not all of the work performed within a company project will necessarily fall within the scope of the SR&ED project. Also, it is possible that the same company project contains one or more SR&ED projects, some of which may involve experimental development and some of which may involve basic research or applied research.

For companies engaged in eligible SR&ED activities, there is a need to look seriously at the processes around documenting those activities. The onus is on claimants to document what was done, why it was eligible and how much it cost. Companies document business projects (if they document anything). Most have difficulty defining SR&ED projects – as distinct subsets of company projects – and therefore can’t effectively allocate costs to SR&ED.

In order to identify SR&ED projects, claimants must learn to distinguish between “routine development” or “standard practice” and eligible experimental development (“ED”). As you can probably see from the discussion of ED below, it requires a certain subtlety that often escapes developments caught up in the pressures of product development cycles.

Experimental development (“ED”) versus standard practice

There is a difference between experimental development work and development work based on standard practice in established fields of engineering or technology.
Standard practice is the application of techniques, procedures and data that are generally ac-cessible to competent professionals in the field. In terms of development work, standard prac-tice refers to directly adapting a known engineering or technological practice to a new situation when it is reasonably certain that the known technology or practice will achieve the desired ob-jective of the project. Under these circumstances, there is no technological uncertainty. Also, although development usually involves carrying out work in a systematic manner, what sets SR&ED apart is adopting the scientific method to reduce or resolve technological uncer-tainty. Development by standard practice is therefore not SR&ED. However, departing from standard practice does not necessarily mean the work is SR&ED. The work must also meet the definition of SR&ED in the ITA. So even though work can be scientific or technological in na-ture, it may not necessarily be SR&ED.

Ideally companies that rely on SR&ED incentives can learn to distinguish eligible SR&ED from routine development. While a company’s own development staff should be suitably skilled and understand standard practice in their field, often the nuance of some of these concepts is very difficult. To reduce the risk claimants can hire consultants who work on a contingent basis, or take advantage of the CRA’s Pre-Claim Project Review service.

My firm can assist companies by reviewing their project descriptions, identifying ‘contemporaneous documentation’ and using existing documentation as a basis for claiming SR&ED. For companies that prefer a ‘reduced risk’ model we can refer a full service firm or recommend the CRA’s PCPR service.

Differing Views on Innovation in Canada

Do concerns regarding the effectiveness of Canada’s SR+ED Program stem from an incomplete understanding of the state of innovation in Canada?

by Rob Farrow, CPA, CGA President, Sutton Levinson Inc. (from a document presented to the CRA November 6, 2013)

 As recently as September 9th of this year the Conference Board warned that “Canada’s economy is on a ‘path to mediocrity’ as innovation lags”. At about the same time the Startup Genome was reaching a much different conclusion. Their dataset was heavily skewed towards early stage startups. The report was co-authored by a number of entrepreneurs, included contributions from Steve Blank (Stanford University) and Ron Berman (UC Berkeley), and was supported by Telefónica Digital – a global business division of Telefónica S.A.

I have included a copy of that report with our submission.

At Sutton Levinson Inc (“SLI”) I believe that I speak for my colleagues when I say that we are committed to helping early stage companies grow. For that reason we believe strongly in the value of the SR&ED program.

According to STARTUP GENOME study, Toronto, Vancouver and Waterloo are 8th, 9th, and 16th respectively in terms of their importance as global technology hubs. If this is true – and we expect that it is – it may be in large part due to our generous tax incentives. While the US dominates with 6 recognized technology hubs, Canada is clearly performing well with 3 in the top 20.

In our view the greatest challenge facing early stage technology companies is clearly access to capital for commercialization:

Excerpts from STARTUP ECOSYSTEM REPORT 2012:

  • “If Toronto does not improve its funding climate, entrepreneurs may relocate to the nearby

Startup Ecosystems of NYC and Boston where funding prospects are much better.”

  • “Toronto’s startup ecosystem is self-sufficient. However, policy makers can help closing the funding gap by attracting late-stage venture funds through tax breaks and incentives, and investor-friendly policies.”
  • “The funding climate for startups in Vancouver is insufficient, with startups receiving 80% less funding than startups in SV. They receive 72% less in Stage 2 (Validation) and 97% in stage 4 (Scale).  The late stage funding market basically doesn’t exist for Vancouver startups.”

Perhaps the Startup Genome’s perspective is different because they are closer to the action and focused more on start-ups than the Conference Board of Canada. Quite frankly at SLI our focus is also on start-ups and early stage companies. We recognize their funding challenges and have developed connections locally within the investment community. Companies at this stage lack resources and experience. As a result, in some ways they actually need more sophisticated help than their later stage counterparts.

In any event we think it is important to recognize our successes and we believe that Canada’s SR&ED incentive program continues to be a success. The emergence of Toronto, Vancouver and Waterloo as global technology hubs certainly owes a debt to the SR&ED program.

In recent years there has been a great deal of discussion about Canada’s inability to leverage our

investment in R&D incentives to improve productivity. We believe that it is the lack of venture capital for commercialization that is the real culprit. However there are certainly some ‘intellectuals’ who have an almost religious aversion to government incentives of any kind.

 CONCERNS WITH THE EFFECTIVENESS OF THE SR&ED PROGRAM

Concerns in Ottawa around the effectiveness of the SR&ED program culminated with the Jenkins Report that made the same mistake that the Conference Board made in September of this year:

  • “The federal government recognizes that, despite its high level of federal R&D support, Canada continues to lag other countries in business R&D spending, rates of commercialization of new products and services, and productivity growth”

As a result we are taking a look at how the SR&ED program is being delivered.  At SLI we note with some concern that the latest revision of Form T661 collects detailed information about the fee arrangement between claim preparation services and taxpayers.

We applaud the agency’s efforts to target unscrupulous service providers and to improve the quality of claims.  We understand that the agency has concerns over contingent fee arrangements. It is, however, claimants themselves that dictate the structure of our engagement terms. Start-ups most often demand contingent arrangements for 3 reasons:

1.   Cash flow – start-ups with little cash can fund the claim preparation fee using the tax credits received and delay payment until a refund is received

2.   ‘Insurance’ that claims are well-prepared (at least partly because of the existence of unscrupulous or incompetent practitioners)

3.   Perceived inconsistency in the determination of technical eligibility by the CRA (understandable given the rapid pace of technological change, the fact that determinations are inherently subjective and that unsuccessful claimants invariably blame the reviewer)

While we understand that the Canada Revenue Agency (“CRA”) may have concerns that service providers are receiving too large a proportion of the tax benefits that were meant as an incentive to SR&ED performers, we must point out that data being collected relates only to the fee and ignores the nature of the service being performed.

We don’t believe that all service providers offer equivalent services

The majority of our clients are start-ups or early stage and are unaware of the documentary requirements of the SR&ED program. While they almost invariably have contemporaneous documentation, they typically have not considered how to implement an activity-based costing

system that ties stand-alone systems to financial accounting records. Implementing such systems and

training our clients in their use, is a significant part of the work that we perform on their behalf.

In the case of start-ups, they may often require remedial bookkeeping when their records are clearly inadequate. In at least one instance we had to properly segregate payments to contractors and employees that had been intermingled by the bookkeeper. In the course of doing that work, we became aware of a significant error on the cut-off for the prior year, which their accountant failed to notice in the preceding year.

During our first year of operation, there are also numerous tax issues that we’ve had to address including:

1. Public company filing as a CCPC (a client we didn’t accept)

2. Company trying to claim EPSPs as SR&ED-eligible – when in fact they weren’t even EPSP- eligible

3. Issues around the valuation of VCC shares going into RRSPs

4. Taxation of and accounting for assistance of various types

5. Reconciliations of Income per financial statements with income for tax purposes

These are examples of the issues that have arisen with clients who are professionally represented. However, many early stage companies choose to use non-designated accountants and bookkeepers as a cost-savings. In addition, we have noticed a number of professional colleagues who represent clients without registering in public practice, presumably to avoid regulatory oversight.

We note that accounting regulatory bodies restrict their members from providing assurance services, unless they can demonstrate the required experience. However there is no corresponding restriction on members who have a background in assurance, who seek to provide taxation services.

In many cases practitioners’ expertise is primarily related to the eligibility of the technology. For many of them a review of the underlying accounting and related tax issues is simply outside of their area of expertise.

On average between 40% and 50% of hours spent by SLI relate to tax and accounting issues. Further, about 10% of our time spent results from our internal technical review process. Taken together we believe that we offer a robust process to our clients. Clearly this is not the case with many practitioners who provide primarily technical writing services.

For the reasons outlined, we trust that the CRA will not place too much reliance on statistics generated from these new forms, or at least understand the limitations of what is being measured.